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What is Bubble Theory?

Definition of Bubble Theory

Bubble Theory is a theory that suggests prices of assets can temporarily rise, so that an asset's current value in any given market is significantly distorted from its true value to such an extent that these bubbles are easily identifiable. Normally, however, these 'bubbles' are only identified in retrospect after a sudden drop in share value and is colloquially referred to as the 'bubble bursting'. The first generally accepted case of 'bubble' trading occurred in the Netherlands in the 1630s and centred around the price of tulips, a key Dutch export product at the time. At the peak of 'tulip mania', in March 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. In stock markets, when P/Es become very high it is possible that a bubble is growing about a particular stock or sector. The average P/E for US equities from 1900 to 2005 was 16 (arithmetic mean), but in many emerging markets where expectations are high and a weight of money is looking for a home (China recently had been a good example of this trend) these P/Es are much higher.
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